Israel's Tax Authority explains its stance on classification of SAFE instruments

• On 16 May 2023 the Israeli Tax Authority released a statement, outlining the conditions under which investments made using Simple Agreements for Future Equity (SAFE) would be considered a down payment for future issuance of company shares (rather than a loan).
  
  
• Consequently, no tax event would occur upon the issuance of future shares in a company under a SAFE, and there would be no withholding obligations for the issuing company.
  
  
• Investors who utilize SAFE instruments in Israeli technology companies should carefully review the terms of their investment agreements to understand any relevant Israeli tax implications.
   

On 16 May 2023, the Israeli Tax Authority (ITA) responded (pdf) to an inquiry from the Israeli Advanced Technology Industries (IATI) organization regarding the classification of Simple Agreements for Future Equity (SAFE) instruments commonly used by early-stage startup technology companies to secure initial funding.

Typically, under SAFE arrangements, investors provide cash to companies in exchange for the right to participate in the issuance of a specific number of shares in future investment rounds when the value of the shares becomes clearer (referred to as "Future Shares"). Normally, the value of the Future Shares issued exceeds the amount invested by the investors. Therefore, there has been a concern that the ITA might classify the discount on the Future Shares upon their issuance as interest income subject to withholding tax by the issuing company, even though SAFE arrangements do not normally involve interest.

In its response, the ITA outlined specific terms and conditions under which issuance of Future Shares to SAFE investors would not be considered a tax event and the issuing company would not be required to withhold any tax from the investors.

The main criteria applicable to companies issuing shares under a SAFE arrangement are as follows:

• The company is a private company operating in the technology industry, with the majority of its expenses (accrued by the issuance date) classified as research and development (R&D), manufacturing or marketing expenses related to R&D-developed products.
  
  
• The company's assets are primarily (in terms of value) not real estate rights or rights related to the exploitation of natural resources in Israel.
  
  
• The company has not raised capital based on a known share price within the three months preceding the closure of the SAFE arrangement.

The main requirements for SAFE arrangements to be eligible for the aforementioned treatment are as follows:

• The amount invested by a single investor under the SAFE arrangement does not exceed ILS 40 million (approximately USD11 million).
  
  
• Investors have the right to transfer their rights under the SAFE arrangement to third parties (subject to company approval) until conversion.
  
  
• The agreement is not labeled as a loan or debt agreement.
  
  
• Conversion to company shares is based solely on a predefined mechanism triggered by specified events, such as an initial public offering (IPO) or an investment round.
  
  
• Investors do not have the right to receive a cash return, except through the conversion to company shares or receiving consideration from the sale of all company shares.
  
  
• If investors receive a return of their invested funds, they are entitled only to the amount invested and no additional cash or in-kind benefits during the period between the investment date and the conversion date.
  
  
• The discount on the Future Shares is not determined in a linear manner by the time of investment.
  
  
• The company must not deduct finance expenses in any way, including by capitalizing finance expenses.

Regarding the conversion of SAFE to Future Shares:

• Conversion should occur as part of an investment round in which at least 25% of the raised funds are not provided by SAFE investors.
  
  
• Realization of Future Shares should follow the below criteria:
  
  
• The sale of Future Shares generally must occur at least 12 months after signing the SAFE agreement or 9 months after the conversion to Future Shares.
  
  
• The sale may occur within a shorter period of time, as long as the date of the realization of Future Shares applies to one of the following types of transactions:
  
  
• The sale of all company shares held by the majority of shareholders (excluding option holders or shares derived from stock-based compensations to employees).
  
  
• A sale in which consideration is not paid by the company but by a purchaser of shares who is not related to the company or holding less than 25% of the company.
  
  
• The consideration received by SAFE investors during the realization of Future Shares is similar to that received by holders of the same class of shares.

SAFE arrangements that do not meet the aforementioned terms are not automatically classified as debt but must be examined individually to determine their classification for Israeli tax purposes.

It is highly recommended to review existing SAFE arrangements to understand potential risks and tax implications and to carefully examine future SAFE arrangements to better understand the Israeli tax treatment upon implementation.

For additional information with respect to this Alert, please contact the following:

EY Israel, Tel Aviv
 

• Ziv Manor
  
  
• Yaron Kafri
  
  
• Motti Tagar
  
  
• Ram Gargir
  
  
• Dafna Lieber
   

Ernst & Young LLP, Israel Tax Desk, New York
 

• Mark Alon

Published by NTD’s Tax Technical Knowledge Services group; Carolyn Wright, legal editor

For a full listing of contacts and email addresses, please click on the Tax News Update: Global Edition (GTNU) version of this Alert.